Why the next big ideas might not get money they need

Jean-Noel Barrot

An earlier version of this column included a misspelling of Peter Thiel’s surname. It has been corrected.

Concern is mounting that the venture-capital model might be broken. Returns have been relatively poor in the past decade. More importantly, perhaps, the innovation outcome has been somewhat disappointing. As PayPal cofounder Peter Thiel complained, “We wanted flying cars; we got 140 characters.”

One key reason for this might be the way venture-capital funds are typically structured. Such funds have been organized for decades as limited partnerships, raising commitments among external investors to be invested and returned within 10 years.

This 10-year horizon is somewhat arbitrary. It was initially used by partnerships formed to develop real-estate projects or explore oil fields. In the 1950s, the first venture funds adopted the template of these partnerships. Virtually all funds are now organized this way, irrespective of their investment targets. While this contractual structure might have been perfectly suited to fund the waves of innovations of the 1980s and 1990s, it might not be appropriate for the long-term innovations that are emerging today.

The closer a venture-capital fund is to the end of its investment life, the less likely it is to fund younger, more innovative start-ups.

Indeed, some venture-capital investors have been shying away from fields in which innovation takes a long time to unravel, such as life sciences. In a survey released in 2011, the National Venture Capital Association found that 39% of VC firms had decreased their investments in life-sciences companies, and planned to decrease them even more over the next three years. The main reason cited was the lengthy FDA approval process. VC firms reported that they were shifting investments away from critical therapies against cardiovascular disease, diabetes, obesity, cancer and neurological diseases.

In a recent study, I confirm that the investment horizon of these funds significantly affects investment decisions. The closer a fund is to the end of its investment life, the less likely it is to fund younger, more innovative start-ups. Funds closer to liquidation tend to select companies that are 3.5 years older, have already received five prior rounds of financing,and have a 9% smaller probability to be at the seed or early stage of development. These companies are growing their patent stock less than companies that receive funding from long-horizon investors.

This does not mean that venture funds are not doing their job well. Instead, this suggests that they take their contract as given and optimize their portfolio of projects accordingly. The most experienced venture-capital investors seem to be highly successful at adapting their investment strategies to their horizons. By selecting innovative projects early in their tenure clock, and moving to more mature projects later on, they increase their probability of a successful exit.

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This effect of VC funds’ contractual structure on investment decisions turns out to be most important in downturns. When the market has been bullish, investment horizon plays a lesser role, possibly because the appetite for innovation increases. However, during severe hard times, the sensitivity of investment decisions to time horizon is stronger, although this is perhaps when innovation financing is needed the most.

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Hence, the traditional VC model might not be suited for the funding of innovations that take a long time to produce observable outcomes. Based on this study, venture-capital funds and limited partners should consider experimenting with different contractual lengths, adjusted to the duration of their expected investments. When faced with investors reluctant to entrust them with capital for longer than 10 years, VCs could, for instance, offer to make it easier for limited partners to liquidate a fund earlier, if needed.

Prof. Jean-Noel Barrot’s is Asst. Prof. of Finance at the MIT Sloan School of Management. His work on investment horizon and innovation in private equity funds was awarded the Coller Institute Prize for Private Equity Research 2012. He is the author of “Investor Horizon and Innovation: Evidence from Private Equity Funds.”

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